Time for reflection

Reflections on the first quarter of 2009

This first quarter of the year has delivered relatively few surprises. In January, Citibank reported heavy fourth quarter losses, Bank of America requested government support following losses accumulating in newly acquired Merrill Lynch, and, in the UK, Gordon Brown and Alistair Darling were forced to announce a 'second' bank rescue plan. In February, the Organisation for Economic Co-operation and Development (OECD) advised that developed economies had suffered their largest contraction in output in 50 years during the last quarter of 2008. Furthermore, they estimated OECD economies would shrink in size by 4.9% in 2009, putting 25 million people out of work and further predicted unemployment to rise to 9.9% in 2010 across the 30 member countries. Meanwhile, the World Trade Organisation (WTO) advised that manufacturing firms in the US, Europe and Asia were struggling with the worst recession in 60 years as evidenced by corporate earnings downgrades on a daily basis.

Capital markets have reflected the deteriorating economic landscape with the MSCI World Index ($) down 12.5%, the S&P 500 down 11.7% and the FTSE 100 down 11.5% during the first 3 months of the year. These numbers, however, mask a very strong March rally in equity markets which rose sharply post the 6^th of March low where we witnessed the S&P 500 below 700 points for the first time since 1996. The same 3 indices delivered returns of 7.2%, 8.5%, and 2.5% over the month of March. The strongest equity returns were delivered by the developing nations of the world, with the MSCI Emerging Markets Index ($) returning 14.2%. The catalysts for this reversal in investor sentiment were numerous; the continued raft of government stimulus plans and the quantitative easing programmes announced by the Federal Reserve, Bank of England and Bank of Japan being chief amongst them. Spirits were further boosted by a trickle of economic data that was much more encouraging than had been seen in previous months. For example, in the UK mortgage approvals rose unexpectedly to reach levels not seen since last May and in the US figures revealed improving consumer sentiment, an increase in durable goods orders and a rise in new home sales - the first increase in 7 months. In China, the government's stimulus package appeared to be gaining traction as a pick up in industrial production emerged alongside a rising manufacturer's purchasing managers index.

Perhaps the strongest catalyst of all was US Treasury Secretary Geithner's announcement of his Public Private Investment Programme to create a market for the distressed toxic assets held on the balance sheets of commercial banks in the US. Market participants reacted positively to this plan and there is a sense this could help free capital and assist the banks to commence lending once more. This sequence of positive news flow, ahead of what we now know has been deemed a successful and productive G20 summit, has created an air of optimism across markets. This reaction suggests that a highly destructive deflationary depression may now be avoided.

Looking ahead

The key questions posed by investors today include; are we seeing the green shoots of recovery? Is this a false dawn? Are we facing something in between? On the downside it is apparent quantitative easing in both the US and UK has yet to reduce corporate borrowing costs to a level conducive with sustainable recovery. On this basis deflationary risks in the period ahead remain very real. Moreover, the potential for an extended fiscal boost is limited for many countries due to rapidly deteriorating public sector balance sheets. Governments continue to accumulate enormous levels of debt which will have to be serviced and ultimately repaid. This will ultimately serve as a protracted drag on public spending and consumer spending via the increased tax rates that will inevitably follow. Whilst currently investors have an appetite for this Government debt, there are limits as to what markets will credibly accept. Mervyn King has already fired a shot across Gordon Brown's bow on this issue. Unemployment is rising sharply, leading consumers to be more intent on saving and repaying debt, rather than spending money on goods and services.

Notwithstanding the above, the positive economic news flow cannot be denied. The data released in the past few weeks is supportive of the view this downward leg of the cycle is stabilising. Some cyclical areas of the markets have begun to reflect the likelihood of industrial improvement. Rallies across emerging markets and the rise in commodities prices are indicative of this. In the course of time government spending programmes will create jobs and near zero interest rates will boost the housing market as well as eventually stimulate a rise in household and corporate spending.

These conflicting set of views help explain why markets have been, and continue to be, volatile. From our perspective we believe it is too early to say with any conviction that the economic stimulus packages in the developed world are working. Activity 'feels' weak and has continued to decline through this first quarter. In the East, it appears economic growth is still being delivered, however, at reduced rates and our long held view remains that China, on its own, will not pull the world out of recession.

Our hopes for this second quarter of 2009 are for further evidence the worst is over and the spirit of economic and geopolitical togetherness engendered at the G20 is maintained. Our fears centre around a banking system which remains very fragile and a rising rate of unemployment which chokes economic recovery and stokes social unrest in the worst affected countries and regions of the world. On a global scale, the evidence is that in real terms this has been the worst ever bear market by a considerable margin. For now we suspect further bad news will continue to depress markets for much of the remainder of 2009 and a sustainable recovery still looks some way off.